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HFT uproar revives calls for “trading tax” and other bad ideas

The weeklong uproar over high-frequency trading has awakened the public and government regulators to what investment pros have known for years: The stock market has evolved into a dizzying multi-player videogame spread over dozens of electronic hubs and featuring dark “members only” levels, with scores tied to microsecond moves and fractions of pennies.

As a result of Michael Lewis’ book Flash Boys and the media tizzy it’s prompted, pretty much all the inner workings of stock trading are going to be scrutinized by fresh eyes and regulators to “do something, anything” to fix it.

The FBI is investigating some high-frequency trading practices under a broad insider-trading investigation, presumably focusing on whether the firms’ early peeks at others’ stock orders represent an unfair advantage that rises to the level of illicit activity. New York Attorney General Eric Schneiderman has also promised an inquiry along the same lines.

This rush to find villains and remedies means that some long-shot ideas for financial regulation have been resurrected, such as proposals for a financial-transaction tax, a small levy on every trade.

As Yahoo Finance’s Jeff Macke and I discuss in the attached video, such rules have been tried elsewhere, and rather than discourage speculation and raise effortless revenue, they tend to simply chase traders to other venues or reduce market liquidity.

Among the sinister-sounding features of our markets are “dark pools,” privately hosted electronic trading venues where institutional investors and brokers swap shares away from the public exchanges. These have existed for more than a decade, but now account for a large minority of equity volume, raising fears that the publicly displayed quotes don’t always reflect the true, best price available for shares at a given moment.

Few would deny that the U.S. market structure is fragmented, overly complex, somewhat opaque and vulnerable at numerous technological intersections. Yet this system evolved from regulatory-reform efforts to break the old market-makers monopoly on middleman profits, encourage competition for public stock orders and lower costs for most investors. This led to trading in pennies instead of eighths of a dollar and promoting electronic rather than floor-based trading.

It’s largely worked, as trading costs have collapsed over the past dozen years, enabling exchange-traded funds, for example, to offer small investors broad exposure to the stock market at a cost of less than one-tenth of 1% of assets per year.

Yet the splintered nature of volume and constant speculative gamesmanship has frustrated large institutional traders and raised fears that the system is too reliant on the kinds of opportunistic middlemen who can back away from markets in tumultuous times.

It’s ironic, in a way, that small investors are indignant about this state of affairs, considering that they’ve never had it better in terms of cheap stock trades at the optimal price.

The scrutiny of all elements of market structure has dented the stock prices of online retail brokerages such as Charles Schwab Corp. (SCHW) and TD Ameritrade Holdings (AMTD) in recent days, as Wall Street worries that the practice of selling retail orders to big market makers might be curtailed.

While this “payment for order flow” game has come in and out of focus among reformers and regulators, it’s one of the key reasons commissions and fees to smaller investors remain so low, according to firms. What’s more, retail investors are more likely to get a better price as big traders take the other side of their trades rather than try to front-run them.

The most desirable “fixes” to the system might be to eliminate rules that allow exchanges to distribute quotes at different speeds – to create more uniform data-dissemination protocols. And some sort of “central order book” to offer a clearer real-time view of the available prices at the dozens of venues makes sense as well.

But whatever reform efforts are considered, be ready for the law of unintended consequences to be in full force, as folks start tinkering with a system that – for all its clear weaknesses – has become dramatically more efficient and less costly over time.